Bond Risk Rising with Rates

The Federal Reserve is raising interest rates. The current Fed Funds rate is 0.88%, up from zero in December 2015. By the end of 2018, the FOMC projection is for the Fed Funds rate to be 2.13%. The market expectation is 1.75%. In either case, the Fed Funds rate may more than double in the next couple of years and show at least a 1% increase.

The impact of a 1% rise in interest rates is negative for many bonds. Below is a chart showing the sensitivity of various bonds to a 1% increase in rates.

The price returns on convertible, high yield (U.S. HY) and floating rate bonds are also negative. The total return of these three bond categories is positive because of the relatively high yield overcoming the loss of face value.

If interest rates rise by more than 1%, the bond problem becomes worse.

Bonds may no longer be a way to de-risk your portfolio. In the current market environment, bonds may be adding to the risk of loss.

The Active Equity Answer

World economies are growing. The chart below shows manufacturing activity by region and country. Numbers greater than 50 indicate expansion. Green represents growth. The time scale runs across the top from April 2015 on the left to March 2017 on the right. For March 2017, all areas are green(ish) and greater than 50 except for Greece, Korea and Brazil. The global PMI is 53.0. At 49.6, Brazil looks like it is gaining strength and may move into expansion territory soon.

In the Fed Minutes released on Wednesday, some Federal Open Market Committee participants viewed U.S. equity prices as “quite high” relative to standard valuations. The good news is the equity market is global. Year-to-date, equities from all major regions have outperformed bonds, REITs and commodities. International equities have been particularly strong.

After an eight year recovery in U.S. equities and a more than three decade bull market in bonds, we may be entering a new investment chapter. In the new chapter, active asset allocation outside of the U.S. and active portfolio risk mitigation may deliver materially better results with lower risk than the S&P 500 index and the traditional buy-and-hold 60%/40% stock/bond portfolio.

One of the keys to investing is sifting through all available information and sticking to a plan. Somehow, we need to control our emotions about something that is very important to each of us. We invite you to call or email anytime if you have questions about how we can help you with your wealth management. Please give us a call at (415) 249-6337 or email us at info@uscapitalwm.com to learn more.

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Pursuant to the provisions of Rule 206(4)-1 of the Investment Advisors Act of 1940, we advise all readers to recognize that they should not assume that recommendations made in the future will be profitable or will equal the performance of past recommendations. This publication is not a solicitation to buy or offer to sell any of the securities listed or reviewed herein. The contents of this letter have been compiled from original and published sources believed to be reliable, but are not guaranteed as to accuracy or completeness. Nicholas Atkeson and Andrew Houghton are also principals of US Capital Wealth Management, a registered investment advisor. Clients of US Capital Wealth Management and individuals associated with US Capital Wealth Management may have positions in and may from time to time make purchases or sales of securities mentioned herein.

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